ACTIVITY BASED COSTING

By : Aditi Balbir
REQUIREMENT OF COST SYSTEMS
• Valuation of inventory and measurement of the cost
of goods sold for financial reporting.

• Estimation of the costs of activities, products,

services, etc.

• Providing economic feedback to managers and

operators about process efficiency.

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 Today’s businesses are working in an increasingly complex
environment.

Use of Advanced Technology

Product Life Cycle

Product Complexity
Channels of Distribution
Quality Requirements

Product Diversity 3
 Composition of Cost

100

0
1 2 3 4
Direct Material Labour Overheads
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 CONVENTIONAL COSTING
• Total Cost = Material + Labour+ Overheads
• Overheads are allocated to the products on volume based
measures e.g. labour hours, machine hours, units produced

Will this not distort the costing in the new

environment?

ABC provides an Alternative.

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Conventional Costing AB Costing
Economic
Element
Expenses Resources

Work
Activities
Performed
Cost Objects

Product or
Cost Objects
service
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 BASICS OF A B C

• Cost of a product is the sum of the costs of all

activities required to manufacture and deliver the
product.
• Products do not consume costs directly
• Money is spent on activities
• Activities are consumed by product/services 7
 BASICS OF A B C (CONTD.)
• ABC assigns Costs to Products by tracing expenses to
“activities”. Each Product is charged based on the extent
to which it used an activity
• The primary objective of ABC is to assign costs that
reflect/mirror the physical dynamics of the business
• Provides ways of assigning the costs of indirect support
resources to activities, business processes, customers,
products.
• It recognises that many organisational resources are
required not for physical production of units of product but
to provide a broad array of support activities.
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 ABC SYSTEMS ADDRESSES THE
FOLLOWING QUESTIONS:
o What activities are being performed by the
organizational resources?
o How much does it cost to perform activities?
o Why does the organization need to perform those
activities?
o How much of each activity is required for the
organization's products, services, and customers?
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 BASICS OF A B C : HOW?
Cost pools are groups
Steps: or categories of
o Form cost pools individual expense
o Identify activities items
o Map resource costs to activities
o Define activity cost drivers
o Calculate cost

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 IDENTIFY ACTIVITIES
In developing an ABC system, the organisation identifies the
activities being performed:

• Activity Dictionary

o Move material o Respond to customers

o Schedule production o Improve products

o Purchase material o Introduce new products
o Inspect items o Explore new markets
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 ABC ANALYSIS
Control of stores should be greater for costlier items.

Item Quality Quantity Checking

order
A Costly Less Regular system to see that
there is no overstocking as
well as that there is no
danger of production being
interrupted for unwanted
material.

B Less costly Order may be Position being viewed in

on review each month
basis.
C Economical Larger Order in large quantity so
that cost can be avoided
 MAP RESOURCE COSTS TO
ACTIVITIES
 Financial accounting categorises expenses by spending
code; salaries, fringe benefits, utilities, travel,
communication, computing, depreciation etc.

 ABC collects expenses from this financial system and drive

them to the activities performed.

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 ACTIVITIES: TYPES

o Unit level: Performed each time a unit is produced

o Batch level: Performed each time a batch is produced
o Product level: Performed to support production of
different type of product
o Customer Level: Performed to support servicing
customers
o Facility level: Residuary head
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 DEFINE ACTIVITY DRIVERS
 The linkage between activities and cost objects, such as
products, customers,, is accomplished by using activity
drivers.
 An activity driver is a quantitative measure of the output
of an activity.
 The selection of an activity driver reflects a subjective
trade-off between accuracy and cost of measurement.
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 BUILDING AN ABC MODEL

Identify Identify Identify

Resources Activities Cost Objects

Define Define
Activity Resource
Drivers Drivers

Enter Enter Enter

Calculate
Resource Resource Activity
Costs
Costs Driver Qty. Driver Qty.
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PROCEDURE OF ABC CLASSIFICATION

The procedure of the ABC inventory control classification

is summarized in the following steps:
 Determine the annual usage for each item.

 Multiply the annual usage of each item by its cost to get

its total annual money usage.
 List the items according to their annual money usage.

 Calculate the cumulative annual money usage and the

cumulative percentage of items.
 Examine the annual usage distribution and group the
items into A, B, and C groups based on percentage of
annual usage.. 17
 AN APPLICATION
Inventory sheet showing the annual unit usage and unit
cost:
Annual money
Part number Annual unit usage Unit cost
usage

1 1,100 2 2,200
2 600 40 24,000
3 100 4 400
4 1,300 1 1,300
5 100 60 6,000
6 10 25 250
7 100 2 200
8 1,500 2 3,000
9 200 2 400
10 500 1 500 18

The total annual money usage is $38,250.

SORTING THE ITEMS BASED ON THEIR
ANNUAL MONEY USAGE, GOING FROM THE
HIGHEST TO THE LOWEST:

Annual Cumulativ Cumulativ

Part Annual Cumulativ
Unit cost money e percent e percent
number unit usage e usage
usage usage of items
2 600 40 24,000 24,000 63 10
5 100 60 6,000 30,000 78 20
8 1,500 2 3,000 33,000 86 30
1 1,100 2 2,200 35,200 92 40
4 1,300 1 1,300 36,500 95 50
10 500 1 500 37,000 97 60
3 100 4 400 37,400 98 70
9 200 2 400 37,800 99 80
6 10 25 250 38,050 99 90
7 100 2 200 38,250 100 100
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 In the ABC classification, group A includes items that
hold up about 80% of the total inventory money.  To
identify these items, we look down in the table under the
'Cumulative percent usage' column and add items to
group A until we reach 80 or slightly above or below it. 
In the table above, group A should include items 2 and 5,
which represent 20% of the total inventory items.

 Group B includes items that hold up about 15% of the

total inventory money.  We can remove the items in
group A from the table.  The cumulative percent usages
are adjusted by subtracting from them the cumulative
percentage usage of the last item in group A:
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 Annual Cumulati Cumulativ
Part Annual Unit Cumulative
money ve percent e percent
number unit usage cost usage
usage usage of items

8 1,500 2 3,000 3,000 8 10

1 1,100 2 2,200 5,200 14 20

4 1,300 1 1,300 6,500 17 30

10 500 1 500 7,000 19 40

3 100 4 400 7,400 20 50

9 200 2 400 7,800 21 60

6 10 25 250 8,050 21 70

7 100 2 200 8,250 22 80 21

 The same way we used to add items to group A can be
used to add items to group B. We add items to group B
until we reach 15% cumulative percent usage.  For the
inventory table above, group B includes items 8, 1, and
4.

 The items that have not been included in group A nor B

are grouped under group C.

 The plot of the cumulative percent usage vs cumulative

percent of items is illustrated below.  It is clear from the
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graph that the majority of the money tied up is under
group A.
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 ABC: WHERE TO USE?
 High Overheads
 Product Diversity or Multiple Products

 Customer Diversity

 Service Diversity

 Stiff Competition

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 EXAMPLE PRINTING COSTS:
 Much of the costs of printing a book are in setting up the
document for printing.
 Suppose the set up costs per month are $168,000 and we
do 2 set ups.
 The demand for book A is 2,000 copies requiring 1 set
up
 The demand for book B is 40,000 copies requiring 1 set
up

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 SOLUTION
Using ABC we obtain a cost per set up of $168,000/2
=$84,000. Then we divide the allocated cost by the size
of each book run.
The printing set up cost of Book A
= $84,000/2,000 = $42
The printing set up cost of Book B
= $84,000/40,000 = $2.10

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 PROS AND CONS OF ABC
Benefits:
• ABC is less likely than traditional costing to under cost
or over cost products.
• ABC may lead to improvements in cost control.

Limitations:
• ABC is expensive to implement relative to the
traditional system.

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NUMERICAL 1
• PQR Ltd. manufactures four products, namely A, B, C
and D using the same plant and process. The following
information relates to production period October, 2007:
Product A B C D

Output in units 1440 1200 960 1008

Cost per unit

Direct Materials (Rs) 42 45 40 48
Direct Labour (Rs.) 10 9 7 8
Machine hours per 4 3 2 1 28
unit
The four products are similar and are usually produced in
production runs of 48 units per batch and are sold in
batches of 24 units. Currently, the production overheads
are absorbed using machine hour rate. The production
overheads incurred by the company for the period
October, 2007 are as follows:

 Machine department costs

(rent, deprecation and supervision)
1,26,000
 Set-up Costs 40,000
 Store receiving costs 30,000
 Inspection 20,000 29
 Material handling and dispatch 5,184
During the period October, 2007, the following cost drivers
are to be used for allocation of overheads cost:

 Cost - Cost driver

 Set-up Costs - Number of production runs (batches)
 Stores receiving Requisition
raised
 Inspection Number of production runs
(batches)
 Material handling and dispatch Orders
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executed
 It is also determined that:
(i) Machine department costs should be apportioned
among set-up, stores receiving and inspection activities
in proportion of 4 : 3 : 2.
(ii) The number of requisitions raised on stores are 50 for
each product. The total number of material handling and
dispatch orders executed during the period are 192 and
each order being for a batch size of 24 units of product.

Calculate the total cost of each product using activity-

based costing.

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 SOLUTION
 Machine department costs of Rs. 1,26,000 to be
apportioned to set-up cost, store receiving and inspection
in 4 : 3 : 2 i.e. Rs. 56,000, Rs. 42,000 and Rs. 28,000
respectively.

 One production run = 48 units. Hence, the number of

production runs of different products:

 A = 1440/48 = 30
 B = 1200/48 = 25

 C = 960/48 = 20

 D = 1008/48 = 21
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TOTAL NUMBER OF RUNS = 96 runs
 One batch order is of 24 units. So the number of batches
of different products:
 A = 1,440 / 24 = 60

 B = 1200/24 = 50

 C = 960 / 24 = 40

 D = 1008/24 = 42

total 192 batches

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NUMERICAL 2
Product A B

Output in units 200 1000

Resource Cost
Customer Support 11000
Commission 40,000

 Customer support is driven by number of calls. For A it

is 500 calls and B it is 200 calls
 Commission is driven by sales. For A it is 100 units and
B it is 500 units
 Facility management cost is 50,000 and should be split
between customer support department and sales 37

department in ratio of 3:2.